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New York State Bar Association Tax Section Report on Dividends

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New York State Bar Association Tax Section Report on Dividends New York State Bar Association Tax Section Report on Dividends Provisions of the Jobs and Growth Tax Relief Reconciliation Act of 2003 September 4, 2003 Report No. 1036 New York State Bar Association Tax Section Report on Dividends Provisions of the Jobs and Growth Tax Relief Reconciliation Act of 2003 This report comments on issues relevant to guidance to be provided by the Treasury Department and the Internal Revenue Service (the “Service”) under section 1(h)(11) and related provisions of the Internal Revenue Code of 1986, as amended (the “Code”).1 The report also notes some areas in which changes to the law may be warranted. Section 1(h)(11) was enacted by the Jobs and Growth Tax Relief Reconciliation Act of 2003 (the “Act”), and provides that certain dividends earned by individual taxpayers are taxed at long-term capital gain rates.2 Section 1(h)(11)’s benefits apply to virtually all dividends paid by domestic corporations, subject to various limitations applicable at the level of the taxpayer. Section 1(h)(11) also applies to dividends paid by “qualified foreign corporations,” a newly minted term that raises many of the more difficult questions addressed by this report. I. Summary of Section 1(h)(11) Section 1(h)(11) provides for a 15 percent maximum tax rate on “qualified dividend income” of individuals and other taxpayers subject to tax under section 1. Included in this category are dividends paid by most domestic corporations and by qualified foreign corporations. For this purpose, dividends do not include dividends from tax-exempt organizations and dividends from mutual savings banks and/or employers for which a deduction is available to the payor. Amounts treated as ordinary income on the disposition of preferred stock under section 306 are treated as dividends for purposes of section 1(h)(11). Mutual funds and real estate investment trusts (“REITs”) are permitted to designate the portion of the ordinary income dividends they pay that is attributable to qualified dividend income, which portion generally will then be treated as such in the hands of their shareholders. In the case of a REIT, an amount broadly comparable to the REIT’s undistributed earnings and profits for the preceding taxable year also is treated as qualified dividend income received by the REIT. Qualified foreign corporations include those that are incorporated in possessions of the United States and, subject to certain limitations, those that are eligible for the benefits of a comprehensive income tax treaty with the United States. If a foreign corporation’s stock is 1 The principal draftsperson of this report was Erika W. Nijenhuis. Helpful comments were received from Andrew N. Berg, Kimberly S. Blanchard, Dickson G. Brown, Peter C. Canellos, Michael Farber, David P. Hariton, Charles M. Morgan III, Andrew W. Needham, Deborah L. Paul, Yaron Z. Reich, Richard L. Reinhold, Andrew P. Solomon, Michael L. Schler, Jodi J. Schwartz, Lewis R. Steinberg, Andrew R. Walker, David E. Watts and Diana L. Wollman. All citations to sections are to the Code or to the Treasury regulations promulgated thereunder, except where otherwise indicated. 2 Pub. Law No. 108-27, 108th Cong. 1st Sess., section 302. 1 readily tradable on an established securities market in the United States, the foreign corporation is treated as a qualified foreign corporation with respect to dividends on that stock. Notwithstanding the foregoing, qualified foreign corporations do not include corporations that meet the definition of foreign personal holding company (as defined in section 552), a foreign investment company (as defined in section 1246(b)), or a passive foreign investment company (as defined in section 1297) in either the taxable year in which the dividend was paid or the preceding taxable year. The Act imposes certain restrictions on taxpayers’ ability to benefit from the reduced rate. As applied to dividends from domestic corporations, the restrictions are similar to those applicable to the dividends-received deduction available to corporate taxpayers, although in some cases quite different in their actual operation. First, the stock with respect to which the dividend is paid must have been held by the taxpayer for more than 60 days during the 120-day period beginning 60 days before the stock’s ex-dividend date. For purposes of meeting this requirement, the holding period is reduced for periods where the holder’s risk of loss is diminished.3 Second, a taxpayer may not benefit from the reduced rate in respect of a dividend to the extent the taxpayer elects to treat the dividend as “investment income” for purposes of the investment interest expense rules -- that is, to the extent that the dividend income may be offset by an interest expense deduction. 4 Third, if a taxpayer receives qualified dividend income from an extraordinary dividend, as defined by section 1059(c), any loss on the sale of the stock is treated as long-term capital loss to the extent of that dividend income. Finally, rules similar to those currently found in section 904(b)(2)(B) will limit the ability of taxpayers benefiting from the reduced rate on dividends to claim foreign tax credits in respect of foreign-source dividend income. These rules will operate to prevent taxpayers from using foreign tax credits to reduce their overall tax burden in respect of dividend income to a level below 15 percent. The legislative history of section 1(h)(11) contemplates that guidance will be issued with respect to information reporting (on Form 1099) on dividends as well as on “substitute” or “in- lieu” dividends received with respect to shares of stock that have been borrowed from a taxpayer. For the 2003 taxable year, taxpayers are to be permitted to rely on the Form 1099s they receive to determine whether to report amounts that they receive should be treated as a dividend eligible for the reduced rate or a substitute dividend that is not eligible for that rate. Section 1(h)(11) applies for taxable years beginning after December 31, 2002, and “sunsets” for taxable years beginning after December 31, 2008. For calendar year taxpayers, therefore, section 1(h)(11) applies for the entire 2003 taxable year (that is, retroactively) and for the 2004-2008 taxable years. 3 These rules generally are the same as those applicable to corporate taxpayers with respect to the dividends- received deduction, except that a different holding period requirement applies. 4 This rule is similar in concept, although different in operation, to the rules of section 246A for corporate taxpayers. 2 II. Summary of Recommendations In forming our recommendations, we have been mindful of a number of practical considerations. The first is that the primary group of taxpayers that are likely to be affected by section 1(h)(11) are individuals. Some of the issues that we discuss are not new, in the sense that they or related issues have been relevant to corporate taxpayers with respect to the dividends- received deduction of section 243. As a group, however, individual taxpayers can be expected to be relatively less sophisticated about U.S. federal income tax issues and have relatively more difficulty in obtaining information and advice about those issues than those corporate taxpayers. In some cases, therefore, we suggest clarifications to the law or to guidance issued by the Service in order to assist those taxpayers and their tax advisors, with the aim of promoting effective administration of the law. Another consideration is that a second group of taxpayers that will be affected by section 1(h)(11) are investment vehicles, such as mutual funds, that are not themselves taxable but are owned by individual investors who are, directly or indirectly, taxable on the income of those investment vehicles. These investors can be expected to engage in more complex transactions with respect to dividend-paying stock that they own, and to have access to a wider group of stocks that pay dividends that may be eligible for the benefits of section 1(h)(11), than most individual taxpayers. In some cases, therefore, we suggest guidance on transactions or issues not likely to be of direct relevance to most individual taxpayers. · The Service should issue a notice or other explanatory guidance explaining the holding period rules of section 246, as well as other shareholder-level restrictions on treating dividends as qualified dividend income. · Clarification should be provided as to whether the Act’s provisions relating to extraordinary dividends apply to non-corporate holders other than individuals. · The Service should provide guidance with respect to stock held in a margin account with a broker that is “rehypothecated” by the broker, clarifying that such rehypothecation does not affect the taxpayer’s holding period for the stock and more generally explaining why substitute dividends are not eligible for the 15 percent rate. New information reporting rules should not have retroactive effect. · The term “readily tradable on an established securities market in the United States” should be defined to include stock of a class that is traded on a national securities exchange or on NASDAQ or a similar system. Such stock should include (a) shares purchased and sold through alternative trading systems, (b) ordinary shares as to which there are ADRs traded on such exchanges or NASDAQ, and (c) restricted stock held by, for example, officers, directors and employees. · A rule or presumption based on a list of objective factors should be available to permit taxpayers to treat foreign corporations that do not have stock traded on an established U.S. securities market as stock of corporations eligible for the benefits of a U.S. income tax treaty. Consideration may also be given to a certification program, but such 3 certification should not be the only basis on which such corporations are treated as treaty- eligible.
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